If you are wealthy enough to belong to America's exclusive 1%, chances are you've worked long and hard to provide your family with financial security.
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"For estates valued greater than $1 million, I would recommend at minimum a term life insurance policy as one of the easiest ways to provide liquidity to pay the estate tax," says Julie Kronhaus, an attorney specializing in estate planning and elder law with Kronhaus Law Firm in Winter Park, Fla.
The remaining 99% of us also can use life insurance to protect our heirs from unnecessary expenses. "Life insurance should play a part in most estate plans," Kronhaus says.
An 'Unhappy Surprise'
Federal taxes may be due on an estate left to heirs when a person passes away. If someone dies in 2012, $5.12 million can be distributed to heirs without any estate tax. Amounts bequeathed more than that limit are taxed at a top rate of 35%.
Kronhaus says that many heirs are unaware of the tax, which comes as an unhappy surprise. Taxes are due to the Internal Revenue Service just nine months after an individual's death. "They do not care that your estate is tied up in real estate -- they just want their money," Kronhaus says.
In addition, many states have their own estate and inheritance taxes that can compound disappointment among heirs. But your life insurance can provide liquidity for your heirs to pay the estate taxes. The two major types of life insurance are:
- Term life insurance. Also known as temporary life insurance, it provides coverage for a set period of time. If you live beyond that time, the benefit expires unless you renew the policy -- likely at a higher rate.
- Permanent life insurance. Provides coverage until death, provided the premium is paid.
Term life policies cost less than permanent life insurance, at least in the early years, making the former especially attractive. "Term life insurance is paid quickly and solves (the estate tax) problem nicely," Kronhaus says.
However, Kevin Bress, an attorney who specializes in estate planning and elder law at PK Law in Baltimore, says term life policies also come with one major drawback. "The obvious pitfall with term insurance is the person runs a risk of outliving the policy," Bress says. "Then they're back to square one in terms of achieving their goal."
Purchasing a permanent life policy to pay state and federal estate taxes is "an age-old estate planning technique," Bress adds.
But the strategy does not work for everyone. Bress warns that people generally wait until they are 50 or older before thinking about buying life insurance to protect an estate. By that time, age and health conditions can make premiums much more expensive.
"Anyone who will be rated for a fairly sizable premium is less likely to embark on a strategy of using permanent life insurance to pay estate taxes," Bress says. "Permanent insurance at that age looks disproportionately expensive to them when compared to what their fixed income is going to be; that can be a deal killer."
How Much to Buy
This year's political turmoil has added an extra layer of uncertainty to estate planning aimed at 2013 and beyond. Unless Congress acts, the amount of money you can pass on tax-free through an estate will drop from $5.12 million in 2012 to $1 million in 2013.
In addition, the top tax rate on estates exceeding those limits will rise from 35% in 2012 to 55% in 2013. Nobody knows what Congress and the White House will agree upon, and a final decision is unlikely to occur until after this November's election. "The law will definitely change on Jan. 1. We just don't know what it will be," Bress says.
Kronhaus notes that many experts believe the new tax-free limit will be in the $3 million range, but that is pure conjecture.
How much life insurance should you buy to make sure all estate taxes are covered? Bress says, "The safest thing to do is to run a projection for what the estate tax would be without the insurance. Then look at the ability to pay the tax from liquidity."
Because next year's limits are unclear, consult with an estate attorney or other tax professional to plan for the various scenarios that might unfold.
Life Insurance Tax Tips for the 99%
Although estate planning tax issues are most likely to ensnare those in the 1%, life insurance still can be used by members of the other 99% to help secure the finances of loved ones, Kronhaus advises. For example, life insurance "is really useful in solving the estate planning issues that develop with second marriages, blended families and business succession plans," she says.
Bress agrees. He conjures a scenario of a couple with two sons, a 100-acre farm and few other assets. One of the sons loves farming, stays at home and works the land as an adult. The other son doesn't care about farming and moves out of state to Minnesota.
"You buy life insurance to cash out the Minnesota child, and the farm goes to the other child," Bress says.
Another example of using life insurance to secure finances would be the couple who purchases a policy to make sure the surviving spouse can pay off the mortgage.
Some situations apply only in certain states. For example, Bress says that some states have an inheritance tax that kicks in when you give money to "remote heirs," such as nieces, nephews and cousins. However, life insurance is exempt from those taxes.
"A person can take $1 million and buy a $1 million life insurance policy," Bress says. "They've instantly wiped out the inheritance tax."
Even if you do not plan to pass on an estate to heirs, life insurance can make a big difference in how heirs prosper after you are gone, Kronhaus notes. " You need to make sure that you have enough coverage for burial, payment of debts and to maintain your family member's lifestyle after you pass away."